Concept explainers
a)
To determine: Amount of
a)
Explanation of Solution
Given information:
Capital budget is $15,000,000
Net income is $11 million,
DPS dividend per share is $2,
Outstanding shares 1 million,
Capital structure is 30% debt and 70% equity.
Calculation of retained earnings:
Therefore, retained earnings needed is amounted to $10,500,000
b)
To determine: Dividend per share (DPS) and pay-out ratio.
b)
Explanation of Solution
Based on the residual dividend model, the amount $500,000 ($11,000,000-$10,500,000) is available for dividends.
Calculation of dividend per share:
Therefore, dividend per share is $0.50
Calculation of pay-out ratio:
Therefore, pay-out ratio is 4.55%
c)
To determine: Amount of retained earnings needed by company K to fund its capital budget, if it maintains $2 DPS for next year.
c)
Explanation of Solution
Calculation of retained earnings:
Therefore, retained earnings available is amounted to $9,000,000
d)
To determine: Whether company maintains its present capital structure with its DPS and maintain $15 million capital budget without raising new common stock.
d)
Explanation of Solution
Person X views that, company does not maintain because, if it maintains $2 DPS, only $9 million of retained earnings is available for capital projects. Though, if the company is to keep up its present capital structure of $10.5 million of equity is needed. This may necessitate the firm to issue $1.5 million of common stock.
e)
To determine: Portion of current year capital budget could have to be financed by debt.
e)
Explanation of Solution
Retained earnings available is $9,000,000
Calculation of Capital budget financed with Retained earnings:
Therefore, percentage of capital budget financed by retained earnings is 60%
Calculation of Capital budget financed with debt:
Therefore, percentage of capital budget financed by debt is 40%
f)
To determine: External (new) equity needed.
f)
Explanation of Solution
Calculation of retained earnings:
Therefore, retained earnings available is amounted to $9,000,000
Calculation of external equity needed:
Therefore, external (new) equity needed is $1,500,000
g)
To determine: Company’s capital budget for next year.
g)
Explanation of Solution
Calculation of retained earnings:
Therefore, retained earnings available is amounted to $9,000,000
Retained earnings availability is equals the required equity to find new capital budget.
Calculation of capital budget using required equity:
Hence, capital budget is $12,857,143
Therefore, if Company R cuts its capital budget from $15 million to $12.86 million, it will retain its DPS $2.00, its present capital structure and still follow its residual dividend policy.
h)
To determine: Actions taken by company when its
h)
Explanation of Solution
Company can take any one of the following four actions,
- New issue of common stock,
- Cuts its capital budget,
- Company cuts the dividends,
- Change the capital structure by using more debt funds.
Company should recognize that every of these actions is not while not consequences to its cost of capital, stock price or both.
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Chapter 15 Solutions
INTERMEDIATE FINAN.MGMT.(LL)-W/MINDTAP
- Residual Distribution Policy Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a 3 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows: Project A: Cost of capital = 17%; IRR = 20% Project B: Cost of capital = 13%; IRR = 10% Project C: Cost of capital = 7%; IRR = 9% Harris intends to maintain its 35% debt and 65% common equity capital structure, and its net income is expected to be 4,750,000. If Harris maintains its residual dividend policy (with all distributions in the form of dividends), what will its payout ratio be?arrow_forwardOptimal Capital Structure with Hamada Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm’s EBIT is $14,933 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.0. What is BEA’s unlevered beta? Use market value D/S (which is the same as wd/ws when unlevering. What are BEA’s new beta and cost of equity if it has 40% debt? What are BEA’s WACC and total value of the firm with 40% debt?arrow_forwardCOST OF CAPITAL Coleman Technologies is considering a major expansion program that has been proposed by the companys information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Jerry Lehman, the financial vice president. Your first task is to estimate Colemans cost of capital Lehman has provided you with the following data, which he believes may be relevant to your task. The firms tax rate is 25%. The current price of Colemans 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity, is 1.153.72. Coleman does not use short-term, interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. The current price of the firms 10%, 100.00 par value, quarterly dividend, perpetual preferred stock is 111.10. Colemans common stock is currently selling for 50.00 per share. Its last dividend (D0) was 4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Colemans beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%. Colemans target capital structure is 30% debt, 10% preferred stock, and 60% common equity. To structure the task somewhat, Lehman has asked you to answer the following questions: a. 1. What sources of capital should be included when you estimate Colemans WACC? 2. Should the component costs be figured on a before-tax or an a after-tax basis? 3. Should the costs be historical (embedded) costs or new (marginal) costs? b. What is the market interest rate on Colemans debt and its component cost of debt? c. 1. What is the firms cost of preferred stock? 2. Colemans preferred stock is riskier to investors than its debt, yet the preferreds yield to investors is lower than the yield to maturity on the debt Does this suggest that you have made a mistake? (Hint: Think about taxes) d. 1. Why is there a cost associated with retained earnings? 2. What is Colemans estimated cost of common equity using the CAPM approach? e. What is the estimated cost of common equity using the DCF approach? f. What is the bond-yield-plus-risk-premium estimate for Colemans cost of common equity? g. What is your final estimate for rs? h. Explain in words why new common stock has a higher cost than retained earnings. i. 1. What are two approaches that can be used to adjust for flotation costs? 2. Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost? j. What is Colemans overall, or weighted average, cost of capital (WACC)? Ignore flotation costs. k. What factors influence Colemans composite WACC? l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.arrow_forward
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